Value strategies in energy shares

There is a compelling opportunity to invest in midstream and pipeline Master Limited Partnerships which now offer 6.5 per cent yields and at least 7-8 per cent distribution growth potential.

Energy was the worst performing sector on Wall Street as oil price crashed 50 per cent in six months in an eerie echo of 2009. Panic selling in the oil market led to a New Year’s bloodbath in global equities, as fears of contagion and forced liquidation of leveraged positions gripped the financial markets. Leveraged balance sheet shale oil exploration and production firms, integrated supermajors, offshore drillers, oil services firms, Canadian tar sand plays were all devastated in the energy crash of 2014.

While a decline in the US and Canadian rig count has begun, oil prices cannot stabilise until Saudi Arabia, Kuwait and the UAE indicate their commitment to an output cut. Riyadh, Kuwait and Abu Dhabi have no interest in playing their traditional role of “swing producer” in a glutted global crude market. The oil crash was so swift and brutal because it resulted from a supply shock (3 MBD extra US shale oil, Libya, Iraq output surge) and a demand shock (Europe/Japan recession, China slowdown). It is unwise to bottom fish in energy shares on Wall Street while West Texas and Brent are in panic selling mode, I believe it is now time to analyse the risk reward potential of attractive energy subsectors. Lord Rothschild’s advice to buy when there is “blood on the street” means there is money to be made via a contrarian energy share investing.

I believe there is a compelling opportunity to invest in midstream and pipeline Master Limited Partnerships (MLP) which now offer 6.5 per cent yields and at least 7-8 per cent distribution growth potential. This means it is all too feasible to invest in midstream/pipeline MLP’s after their savage correction where total return of 15 per cent is now realistic. Fee based contracts, strong cash flow and minimal commodity exposure makes this sector an ideal investment theme after an oil crash at a time when the ten year US Treasury note yield is 1.95 per cent. Sure, project backlog risks rise in an oil bear market and this could increase distribution growth risk. Kinder Morgan (KMI) is an ideal blue chip investment that benefits from the infrastructure growth/LNG markets. It is now entirely possible that MLP’s with “fortress”, underleveraged balance sheets will accelerate growth via takeover bids, as the interest rate cost of project finance is still benign. As US Treasury yields sink, the pipeline and midstream MLP’s become a compelling theme. Another attractive energy sub-sector is refining, given that the Brent-WTI spread is only $2 a barrel now, historically a level where spread widening takes place and boosts the valuations of US refiners. Global refining capacity increase, crude export risks and falling US crude production are the three major risk in the sector, now well reflected in share prices. Tesoro’s share buyback programs, attractive valuation metrics, dividend growth potential and exposure to Alaskan refining spreads make it the natural blue chip to own in this energy sub-sector.

I believe the oil price crash is a disaster for renewable energy and coal stocks. Chinese steel production is slowing. Coal prices face huge downside risk due to Australian/African supply. Peabody Energy (symbol BTU) is road kill in such an awful industry environment. This is definitely not the time to “carry coal to Newcastle” or owning coal stocks on the New York Stock Exchange.

Oil services shares will definitely face lower EPS growth in 2015 as the Seven Sisters, state owned oil and gas colossi and US shale oil producers all slash capex. Halliburton, with its takeover bid for Baker Hughes and its huge exposure to North America, faces major risk. Halliburton could well bottom at 10 times its estimated 2015 EPS of $3 or $30 a share. Oil services is an industry that will face headwinds as price wars and a supply glut grips the world oil market.

Chevron shares have fallen from their July 2014 highs at 135 to 106 six months later. Chevron is America’s second largest supermajor after Exxon Mobil. Chevron is on the eve of a epic oil production growth target above 3 million barrels of oil equivalent trades, thanks to mega LNG projects in Angola, Australia, Mexico and Indonesia. Even if 2015 EPS falls to $10 in 2015, which it will due to the oil crash, Chevron trades at only 10 times earnings and Chevron’s dividend is also hugely attractive as interest rates fall in the debt market.

The US stock market is overvalued with the S&P 500 index at 2060 or 16.7 times forward earnings. This valuation multiple has only been exceeded in 1999 during the Silicon Valley tech bubble or during the peak of the credit bubble in 2007. US equities traded at 11 times forward earnings in September 2011. We have witnessed an epic valuation rerating in the last four years that coincided with the expansion of the Federal Reserve’s balance sheet. However, I expect valuation multiples to contract when the Fed raises money market rates in response to the stronger US economy. Moreover, the surge in the US dollar means earnings risk for US corporate. Europe’s deflation and geopolitical risk in Greece, Ukraine and the Middle East are all potential risk events for the US market. This is the year I expect a 20 per cent correction on Wall Street.


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